Comments Off on Why can PwC charge such superhuman fees? It’s all in the power of bargaining

The liquidation of Carillion continues to feature prominently in the news.

Last week, the story was the fees being charged by PwC, the accountancy firm tasked with salvaging money from the wreckage.

It emerged that PwC’s fees, which take priority in terms of being paid over the various creditors and pensioners, amounted to £20.4m for the first eight weeks’ work. The special manager with overall responsibility has a rate of £865 an hour.

The fees were described in parliament as “superhuman”.

We might reasonably ask how these rates are determined. Why are they not half their actual value? The remuneration would still be very substantial. Equally, why are they not double?

The answer from a basic economics textbook would be that it is a matter of supply and demand. The wage – if such a proletarian term is acceptable in these elevated circles – is set at a level which ensures that there are just enough bean counters to carry out the amount of work which exists.

But it is hard to sustain this argument. The Big Four accountancy firms in the UK take on around 5,000 graduates every year. They receive almost 100,000 applications. There is a long process of whittling down. Eventually, nearly 10,000 get to the final stage, an interview with a partner.

Clearly, many graduates have very strong qualifications. But the wage rate is not bid down by this over-supply.

The argument about how prices, in this case the hourly PwC rate, are set goes back a long way in economic theory.

In the decades just before the First World War, two highly accomplished mathematicians who occupied the top chairs in economics, Alfred Marshall at Cambridge and Francis Edgeworth at Oxford, wrangled over the issue.

Appropriately enough in the week following Cambridge’s triumph in both the men’s and women’s boat races, Marshall was the victor at the time. But, to employ another sporting analogy very much in the news, there was a certain amount of ball tampering along the way.

Edgeworth thought that, in most situations, there was an inherent indeterminacy about the price which emerged. He wrote: “it may be said that in pure economics there is only one theorem, but that it is a very difficult one: the theory of bargain”.

Marshall simplified matters dramatically. He assumed that there are so many economic agents in a market that no single one of them can influence the price. This enabled him to draw, in his own best-selling textbook, the supply and demand curve diagrams familiar to generations of students.

But it was a simplification too far. If no one can influence the price, how is it set?

A lot of modern economic theory is about developing Edgeworth’s view that economics is essentially about bargaining. It makes it much more difficult, but more realistic.

There is no inherent economic justification for the hourly rates which the Big Four accountants charge. They have simply got the best of the bargaining process. Companies need to wake up and start to insist on lower fees.

Comments Off on The balance between wages and capital is shifting – rent seekers had better beware

The first column of a new year is the time for a prediction.

By far the hardest part of forecasting is to identify tipping points. The success rate of calling a break in an established trend is very low.

Accompanied by suitable health warnings, 2018 looks like the year in which the longstanding relationship between capital and labour looks set to change.

The use of the words “capital” and “labour” does not mean that the two are antagonistic in the Marxist sense. Once a country has properly embraced capitalism, there is not a single instance of it ever being abandoned. And “labour” in particular is a very mixed category indeed, covering both university vice chancellors and the people who clean their offices at night.

But it is a useful simplification to describe the players in the evolutionary game of how to divide national income between profits and wages or salaries.

Over the past three decades or so, capital has been winning. The share of profits in national income across the west has risen, and the share of wages has fallen.

The reaction of a number of major companies to President Donald Trump’s cut in corporation tax rate from 35 per cent to 21 per cent suggests that the game is turning.

Almost immediately, firms like AT&T and Boeing announced special bonuses for their workforces. Even the banks got in on the act, with Wells Fargo, for example, raising its hourly minimum wage 11 per cent, to $15 from $13.50. Additionally, the bank plans to donate $400m to community and non-profit organizations in 2018.

The share of wages in American GDP has already started to stabilise. Since 2014, there have been no further falls. Short-term trends like this can be misleading, but for four years the wage share has been constant.

More generally, the surge towards greater globalisation which has characterised recent decades seems to have halted.

Strong political blocs have grown in the west that share a dislike of the liberal, open border consensus which has done so much to hold down the real wages of the less skilled.

The election of Trump is the obvious example. We see it in the vote on Brexit. We see it in the hostility to the free movement of labour shown by governments in Eastern Europe.

On a more parochial level, scrutiny of the “emoluments” (“pay” is too vulgar a word for these panjandrums to use) of chief executives and vice chancellors is intensifying on almost a daily basis.

There is very little resentment of monies made by those who are perceived to have earned it by their personal skill and effort. Entrepreneurs and footballers alike are held in high regard in this respect.

In contrast, there is distinct antagonism towards rent seekers: those at the top who get paid not on their merits, but merely on the basis of the position they hold.

The balance of forces is shifting. Smart politicians and business people should pay close attention during the coming year.

Comments Off on Comparison sites are forcing businesses and economists to rethink price theories

The competition and Markets Authority (CMA) published a report about Price comparison sites at the end of last month. They seem simple enough, but these straightforward sites raise interesting issues for economics.

Overall, the CMA was pretty positive about the DCTs – digital comparison tools, to give them their Sunday best name. The conclusion was that “they make it easier for people to shop around, and improve competition – which is a spur to lower prices, higher quality, innovation and efficiency”.

DCTs offer two main benefits. First, they save time and effort for people by making searches and comparisons easier. Second, they make suppliers compete harder to provide lower prices and better choices to consumers. In short, they bring the real world closer to the perfectly informed consumers and perfectly competing firms in the ideal world of economic theory.

But even in this market, there is an issue which goes right to the heart of much of the information which can be accessed through the internet: how do we know whether we can trust it?

The main problem is that the comparison sites typically provide their services free of charge to consumers. They make money by charging a commission to suppliers.

This creates an incentive for a DCT to promote those suppliers which pay it the most commission. An effective way of doing this on the internet is by the order in which the information on the various suppliers is presented.

It is not that DCTs deliberately provide misleading information, or even that a site leaves off a major supplier which does not pay the particular website enough. But they can put those that pay the most at the top of the list.

Notoriously with Google searches, people rarely click through to anything which is not in the top three results of the search.

Allegedly, 60 per cent of the time, only the site which comes at the very top of is accessed.

Obviously on a DCT, consumers are likely to look at more. That is the whole point of using the site. But although the CMA does not provide hard data on this, it expresses a clear concern about the ways in which the sites rank the suppliers.

How the DCTs themselves set their prices raises a more general question for economics. The basic rule, described in the textbooks since time immemorial, is to set price equal to marginal cost – in other words, at the point where the revenue from one extra sale equals the cost of producing that extra item.

The standard assumption made in teaching generations of students their introductory course to economics is that as the level of output increases, marginal cost first of all falls but eventually rises.

But on the internet, once the site is set up, the cost of dealing with an extra user is effectively zero. The time-hallowed formula of economics is a recipe for bankruptcy.

The internet is forcing companies to innovate in their pricing strategies. And it is forcing economists to rethink some of their theories.

Following the disclosure of salaries at the BBC, it has hardly seemed possible to open a newspaper or switch on the television without being bombarded by stories about pay.

By pure coincidence, an academic paper entitled “Pay for Performance and Beyond” has just appeared. So what, you might ask? Except that it is one of the 2016 Nobel Prize lectures, by Bengt Holmstrom, a professor at MIT.

Holmstrom’s work began in the 1970s on the so-called principal-agent problem. This is of great practical importance. For example, how should the owners of companies (the “principals”, in economic jargon) design contracts so that the interests of the directors (the “agents”) are aligned as closely as possible with the interests of the shareholders?

Many aspects of economics have a lot of influence on policy making. But this is not yet one of them. We have only to think of the behaviour of many bankers in the run up to the financial crisis. Stupendous bonuses were paid out to the employees, and, in examples such as Lehman Brothers, the owners lost almost everything.

It is not just at the top levels that scandals occur. Towards the end of last year, Wells Fargo had to pay $185m in penalties. Holmstrom cites this prominently in his lecture. The performance of branch managers was monitored daily. They discovered that one way of doing well was to open shell accounts for existing customers. These were accounts which the customers themselves did not know about, but they counted towards the managers’ bonuses.

A culture of pressure to perform against measured criteria can lead to problems even when the organisations involved are not strongly driven by money.

The education system in the UK has many examples. But the one given by Holmstrom is even more dramatic. The No Child Left Behind Act of 2001 in the US was very well intentioned. But the test-based incentives eventually led, around a decade later, to teachers in Atlanta being convicted of racketeering and serving jail sentences for fixing exam results.

Holmstrom is in many ways a very conventional economist – his Nobel lecture rapidly becomes full of dense mathematics. He believes that, given the right information and incentives, people will make rational decisions.

This is why his conclusion is so startling.

He writes: “one of the main lessons from working on incentive problems for 25 years is that, within firms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the firm are generally misguided”.

The whole trend in recent years has been to bring even more market-type systems inside companies, from bonuses for meeting potentially counter-productive targets, to devolving budget authority away from the discretion of mangers and handing it to specialised departments.

Holmstrom’s conclusion implies the need for a pretty radical rethink of the way incentives are structured, in both the public and private sectors.

The slow recovery since the financial crisis remains a dominant issue in both political and economic debate.

The economy has definitely revived since 2009, the depth of the recession, in both Britain and America. The average annual growth in real GDP has been very similar, at 2.0 and 2.1 per cent respectively. This is much better than in the Mediterranean economies, where growth over the 2009-2016 period is still negative. Even so, the Anglo-Saxon countries have not expanded as rapidly as they have done in previous recoveries.

A key reason for this is the lack of vision being shown by the corporate sector. True, highly innovative companies like Facebook have emerged over the past decade, and start ups continue to proliferate.

But the longer standing major firms in both the UK and the US have become real stick in the muds. Caution, safety first and an increasingly stultifying bureaucracy envelop them.

The contrast in the behaviour of the corporate sector in the two major financial crises of the 1930s and late 2000s makes this clear. The US national accounts only have data going back to 1929, the year before the Great Recession. But in that year, the net savings of non-financial companies was 3.5 per cent of GDP.

When the recession struck, firms ran down their accumulated cash. Between 1930 and 1934, their net savings were negative, averaging -2.4 per cent of GDP. That amounts to a shift during the recession from a surplus of $650 billion in 1929 to an annual overspend of $450 billion in today’s prices.

In the United States, during the decade prior to the crash, 1998-2007, companies on average had net savings of 2.6 per cent of GDP each year. Since 2009, this has averaged 4.0 per cent. So instead of spending their assets, as they did in the 1930s, companies this time round have simply saved more.

To be fair, American firms are gradually moving back towards their savings patterns prior to the crisis. From 5.4 per cent of GDP in 2010, net savings in 2016 were back down to 3.1 per cent. They are gradually getting their confidence back, their “animal spirits” as Keynes called it.

There are signs of this happening in Britain as well. Between 1998 and 2007, net savings by non-financial companies averaged 1.3 per cent of GDP. From the trough of the recession to now, the annual average has been 2.7 per cent. As in the US, the figure has come down from 2009-2011, when it averaged 3.8 per cent. But firms remain cautious.

But in both the UK and the US, companies are sitting on piles of cash and lack the entrepreneurial spirit to spend it. Boards obsess about fashionable concepts such as lean and agile processes and management. At the same time they set up procurement systems more suited to the old Soviet Union in terms of the tick box mentality which prevails.

Capitalism must be seen to be delivering the goods, and many of our major companies are simply not doing this.

Not many people know that, to use a catch phrase attributed, rightly or wrongly, to the great actor Michael Caine.

The top one per cent of earners contribute 27 per cent of all income tax receipts. To put it in context, just 300,000 people pay nearly three times as much in total as the bottom 15m taxpayers. Despite all the political rhetoric about tax avoidance, high earners cough up a very large amount of money to the Exchequer every year.

Under the Labour government of the 1970s, the highest marginal tax rate was no less than 98 per cent. But the top one per cent of earners paid only 11 per cent of all income tax.

Jeremy Corbyn and shadow chancellor John McDonnell pledged in their manifesto to raise around another £15bn a year in tax from this group. In addition, corporation tax on profits would allegedly raise a further £19bn.

The realism of Labour’s costings as a whole was called into serious question at the time by people such as Paul Johnson at the Institute for Fiscal Studies.

A paper published in the latest American Economic Review produces strong evidence that it is purely wishful thinking to imagine that anything like these amounts could be raised. In the modern world, both skilled labour and capital are highly mobile. There would simply be movement out of the UK altogether.

The authors, Enrico Moretti and Daniel Wilson of Berkley and the San Francisco Federal Reserve Bank, carry out a very detailed statistical analysis of the impact of the different state income tax rates in the US on where highly skilled people choose to work.

Personal taxes vary enormously across the American states. In California, for example, the average tax rate arising on top earners which is due solely to state rather than federal taxation is eight per cent. In contrast, in Texas (and eight other states) it is zero. Over the period of the study – 1977 to 2010 – rates have also varied substantially within individual states.

Moretti and Wilson compile an impressively detailed set of data on individuals they describe as ‘star scientists’, defined as those scientists who are very prolific in generating patents. They examine the location decisions of some 260,000 individuals during the period they analyse.

Tax rates are important not just to individuals in choosing where they want to work. The different corporate tax rates levied by individual states affect where companies such as Microsoft and General Electric locate their most productive and innovative researchers.

There are of course many factors which determine where people and firms decide to locate. But the idea that innovative people will simply sit around en masse and wait to be fleeced is pure fantasy. There may be little chance of the current Labour leadership understanding the real world, but the electorate needs to.